How Time Decay in Options Can Be Your Best Friend - Know Your Options

By
A A A

Today let's talk about one of the 'Greeks' in options trading that doesn't get enough coverage -- and that's Theta.

Theta measures how much value an option will lose each day due to the passage of time as the option gets closer to expiration. This is known as time decay.

You've probably heard the saying that options are a wasting asset -- wasting in that, with each day that passes a small amount of time value ticks away.

Theta is the measurement that quantifies that. And you can literally see how much it'll lose each day even if the underlying stock is unchanged.

In the image below, you can see it expressed as a number. In this example, I've circled the at-the-money option, and you can see it's showing that this option's premium will lose .041 (4.1 cents) with each passing day. That's the equivalent of $4.10.

Polaris (PII), $139.91 (closing price as of 12/18/13, the time of this screenshot)



That means at the end of 30 days, this option will have lost a total of 1.20 in premium or $120, even if the stock didn't budge.

Note: the options nearest the money, and specifically the at-the-money, will typically have the largest theta.

It's also important to know that time decay moves slowly at first, but then really picks up within the last 30 days until expiration. In fact, in each successive week, once it gets within that 30-day period, the time decay accelerates more and more.


Does This Seem Unfair?

Out of context, it sure does. But you didn't think the benefits of big leverage and a guaranteed limited risk in options didn't come with at least a few trade-offs did you?

You can guard against time decay ravaging your option by buying plenty of time. Buy at least 3 months of time, and preferably 4-6 months or more when you can.

If you do find yourself long an option with just 30 days of time left, either sell it and be done with it, or roll into a new month with more time. I call that period the 30-day, time decay, red-zone.

Far more often than not, that one little action of rolling into more time before that 30-day marker can be the difference being winning and losing in options.


How to Use Theta (Time Decay) to Your Advantage

Being long options, whether that's buying a call or a put, means the Theta is working against you.

However, there are many different strategies where theta can work for you.

Those strategies entail writing options, i.e., being short options, either calls or puts, in combination with your longs.

My favorite strategies for this are:

Bull Call or Bear Put Spreads: The trader still has a directional bias in mind, either up or down, but by combining an option he bought with one he has sold, the time decay is now working for him, adding value to his position with each passing day. You would simply write an option further out from the one you bought and theta is now your asset.

Calendar Spreads, aka Time Spreads: This involves buying a longer dated option, and simultaneously selling a shorter dated one. The one closer to expiration will always lose its time decay faster. This trade can be put on with a directional bias. It's also ideal if the trader thinks the market will go sideways. This is a great strategy. Not enough people use it. It's not that exciting. But you are literally taking advantage of a factual and unavoidable dynamic in options, and that's time decay. It's great when you can totally use that to your advantage.

Iron Condor: This is another favorite strategy to benefit from time decay. This trade has four sides to it. It has a guaranteed limited risk. And it's one of the best ways to make money if you believe the underlying stock will go sideways. In fact, this strategy is so accommodating you can even be wrong on which way the stock goes (up a certain amount or down a certain amount) and still make the same maxim dollar amount on the trade. All you have to do is be right on a broad price range to win on this one. "Instead of hitting a bulls-eye, you just need to hit the broadside of a barn."

These are some of the strategies the options pros use. And they're easy and simple enough that virtually anybody can use them.

I won't go through each strategy in this article, but for convenience, I'm including three links to previous articles I've written so you can investigate them on your own.

Bull Call or Bear Put Spreads
(or Bear Call or Bull Put Spreads - yes you read that right)

Calendar Spreads

Iron Condor


Summary

Options are a phenomenal tool. There are tons of benefits you can't get in stocks or other investment vehicles. But, like anything, there are things to watch out for.

But once you know what to look out for, you may find that you can use it to your advantage, ultimately making it one of your biggest benefits.

The pros do.

And you can too.

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our Zacks Options Trader service.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.



To read this article on Zacks.com click here.

Zacks Investment Research



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Options

Referenced Stocks: PII

Zacks.com

Zacks.com

More from Zacks.com:

Related Videos

Stocks

Referenced

100%

Most Active by Volume

79,812,121
  • $12.11 ▼ 5.61%
68,370,136
  • $104.83 ▲ 1.79%
65,036,978
  • $16.60 ▲ 1.22%
64,087,181
  • $8.40 ▲ 5.93%
54,443,769
  • $33.66 ▼ 2.43%
44,944,529
  • $97.82 ▲ 1.50%
40,119,778
  • $45.02 ▲ 1.44%
34,306,166
  • $80.04 ▲ 2.13%
As of 10/23/2014, 04:15 PM

Find a Credit Card

Select a credit card product by:
Select an offer:
Search
Data Provided by BankRate.com